Housing's bad news drum beat pounded Wall Street and Main Street media three times over last week, and squarely in the middle of speculation as to what's ailing the market--apart from harsh wintry weather conditions--is the pervasive belief that pricing is the perpetrator of recovery's sudden demise.
The narrative--as regards the new-home production builder segment--commonly goes like this. A market lift starting in 2012 allowed new home builders to kick-start their engines, but lots, labor, and material supply-line constraints suppressed the flow of inventory into communities whose robust economic fundamentals sparked demand. Limited supply both allowed and encourage home builders to raise prices and tamp back or "meter" new supply, reaping greater margins per unit sold as the demand stream held up.
This mini-tsunami of activity carried through the first half of 2013, checking up approximately when first mention of Federal Reserve tapering of mortgage-backed securities purchases started playing a bit of havoc with mortgage interest rates.
The question may fairly be, if buyers of most of the homes in the first rush of recovery were relatively price elastic, tending to pay more cash, and non-contingent buyers, then what explains the timing of the market slowdown in midyear of last year, if not a combination of mortgage rate increases and volatility, and overly aggressive pricing strategies among new home builders?
Everyone, it seems, has a theory. One of the smartest in the business of interpreting economics, housing's behavioral trends or "Animal Spirits," and the policy measures that from time to time goose the organic relationship between supply and demand, Calculated Risk's Bill McBride, puts it this way:
There are several reasons for the recent weakness:
1) Higher prices. Case-Shiller reported prices were up 13.7% year-over-year in November. Other indexes had smaller increases, but all showed significant price increases in 2013.
2) Higher mortgage rates. 30 year fixed mortgage rates increased last summer from around 3.5% in May 2013 to 4.4% in July 2013. Since then, mortgage rates have mostly moved sideways, but some of the weakness since last summer is probably related to higher mortgage rates.
3) Fewer distressed sales. Although the decline in foreclosures, short sales, and mortgage delinquencies is good news, this has meant fewer overall existing home sales (this isn't a surprise - I've been predicting a decline in overall existing home sales for exactly this reason). Even though overall sales have been declining, equity sales (aka conventional transactions), are actually up year-over-year. Note: Of course fewer distressed sales should be a positive for new home sales, so this doesn't explain some of the recent weakness for new home sales.
4) Less investor buying. This is related to fewer distressed sales. If we use cash buyers as an indicator of the level of investor buying, then the decline in cash buyers in areas like Las Vegas, Phoenix, and Sacramento suggests investors are pulling back.
5) Limited inventory. The sharp decline in inventory over the last few years was a key story for housing (I beat that horse into the ground). There are several reasons inventory has been low: a) Most of the recent investor buying has been "buy-to-rent" and these investors aren't selling, Note: Economist Tom Lawler discussed this two year ago, and he concluded that a significant "share of the decline in the share of homes for sale reflects the acquisition of SF (and condo) properties by investors as multi-year rental properties", b) Is it difficult for people who are underwater (negative equity) to sell, c) Seller psychology: When the expectation is that prices will fall further, marginal sellers will try to sell their homes immediately. And marginal buyers will decide to wait for a lower price. This leads to more inventory on the market. But when the expectation is that prices are stabilizing (the current situation), sellers will wait until it is convenient to sell. d) Low inventory can keep some potential sellers from listing their homes because they can't find a move-up home to buy.
6) Supply chain constraints for New Homes. I noted at the beginning of 2013 "I've heard some builders might be land constrained in 2013 (not enough finished lots in the pipeline)." That was correct - some builders had limited entitled land and there were other constraints too (material shortages, skilled labor in certain areas) - and this limited the number of new home sales last year (sales were only up 16.3% in 2013).
7) And some of the recent weakness in December and January (and February) might have been weather related.
Notice where weather ranks in McBride's ranking of factors impacting current weakness. I'd agree that weather should not be blamed for the extent to which the market has slowed, particularly in the West, Southwest and Southeastern regions.
The big issue here is this. What if the primary reason for a slowdown has very little to do with the weather, and even has not a whole lot to do with overly aggressive pricing. We urged last week, look beyond the headlines.
Consider, if you will, Metrostudy's best markets for new home building for 2014. Have a look here at the top 10 ranked markets:
Now, as you look at those markets, what stands out?
To us, it's clear that you could make a case in each area that there's a strong component of willing and able cash-rich potential buyers, ones without contingencies, whose one strong impediment to entering the market earlier was a fear of looking idiotic for buying a new home when prices were still falling.
Compare that list to CNN/Money's "10 most-affordable small cities," drawn from rankings of the Housing Opportunity Index from the National Association of Home Builders and Wells Fargo. There's nary a cross-over here, and the point is "affordability" in these towns doesn't in this market necessarily translate into "buying power," thanks to policy and loan qualification strictures.
This is anecdotal reasoning at best. But a theory such reasoning leads to is this. The fundamental barriers to further traction in the new-home market have not changed appreciably since the downturn, namely that purchases among entry-level prospects have not taken on a life of their own in this market recovery. They're still on the outside of the market looking in, except in locations where highly robust job and household income growth has sparked expectations of further income growth.
So, if the entry level, first-time buyer market is still on the sidelines, the pool of cash-rich, non-contingency, less-financing-dependent buyers eventually shrinks. That's the phenomenon that has most impacted housing data points this year versus last: investor buyers fueled volume, and cash-rich buyers fueled price increases, and together they made the market what it was.
If those two forces have diminished, which it would seem they have, that explains the fall-off of unit volume demand, and it also explains a reason for a decline in home builder sentiment. Dodd-Frank mandated Qualified Mortgage and Qualified Residential Mortgage guidelines just went into effect January 10, which put an even greater layer of uncertainty on housing finance expectations, so it's no surprise home builder sentiment dove.
Here's the thing, and it means again referring back to McBride's factors #6 and #7, which have to do with supply limits and supply chain constraints.
It's where these two factors intersect with bringing the entry-level, first-time buyer back into the market that leads me to think that it would be wrong for builders to surmise that aggressive pricing is off-base.
The point is aggressive pricing could and should continue for the buyer pool who's more price elastic. The ongoing issue and challenge is adding lots--in some cases B and C and D lots--and reworking the supply chain to extract more costs out of the system so that new-home builders are building again for the entry-level buyer.
Leadership, therefore, can speak confidently and genuinely about their enterprise's opportunity in this ongoing lumpy, choppy, and iffy markets, providing they and their teams outplay all of the other competitors on the lot supply and supply chain fronts. That makes land acquisition and supply chain/purchasing folks pretty damned important in the scheme of things right now.
As one chief executive officer of one of the top five home building organizations in the nation said of the NAHB/HMI fall-off, "I certainly wouldn't say that we're seeing anything but encouragement in our markets." You have to be good to be lucky.